Leveling the playing field for retail investors is an issue that’s finally starting to galvanize European lawmakers. Authorities have recently turned their attention to regulating payment-for-order-flow (PFOF), with European lawmakers debating ways to limit or ban the practice as part of the Markets in Financial Instruments Regulation (MiFIR).
But for all the attention being paid to PFOF, there’s a more insidious threat to investor fairness that’s not getting nearly as much airtime as it should.
We’re referring to the preferential market-making arrangements found throughout Europe but that are particularly prevalent in Germany. While PFOF can pose conflicts of interest, retail trading models in countries like Germany – which we highlighted in a January 2022
The way this model works is that retail brokers send all or most of their customer orders to trading venues with one market-maker per instrument or product class. In return, the market-maker, often affiliated with the exchange, pays a per-order fee to the retail brokers.
To understand how these arrangements rose to prominence, it helps to go back to early 2020, when pandemic lockdowns were fueling waves of activity from retail investors. Alongside the rise of retail trading was a contemporaneous boom in trading apps giving easier and cheaper access to markets.
Some of these new entrants use PFOF as a way to supplement revenues. In the US, PFOF represents a
Restricting access
The venues in question are regulated as multilateral exchanges but have rulebooks and policies that effectively restrict access to competing liquidity providers. One of the largest German retail venues, for example, prohibits non-specialists from deploying algorithmic or market-making strategies.
In our view, the result is a market that behaves less like a multilateral exchange and more like a systematic internaliser (primarily used by banks to transact proprietary liquidity against client orders). These single market-maker venues also use a slimmed-down settlement process, which strips out a chunk of post-trade costs.
Taken together, it’s easy to see why these features make single market-maker venues a compelling commercial proposition for retail brokers. But the inherent conflicts in these models mean retail customers may be routing to venues that maximise their profits rather than seeking the best possible price for their orders.
A February 2022
Missed opportunity
To date, EU regulators have largely declined to address these models. The European Securities and Markets Authority failed to consider the structure of single market maker exchanges in its recent
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The onus now lies with the European Parliament, which also has a say in the final MiFIR text. Despite some initial encouragement, MEPs appear unlikely to ban brokers from having preferential intermediary relationships.
To us, that’s a missed opportunity. While EU regulatory negotiations are notoriously fraught, the MiFIR review provides a window for tackling these problematic arrangements to ensure safeguards are put in place to foster competition and provide better outcomes for individual investors.
